The central bank is the highest monetary institution in national borders that controls money, regulates credit, monitors the financial system, and drafts the economic policy. The central bank plays an important role in ensuring monetary stability and establishing confidence in the economy and growth. Commercial banks are in direct relationship with the public. The central bank is a regulator, advisor, and policymaker. They range from inflation regulation to the lender of last resort among the various functions that it has undertaken, with the most critical being predetermined in value in financial management and coverage.
What is Central Bank?
A central bank is the government organization that manages a country’s money supply, currency, and interest rates. The highest finance organization regulates the banking and financial system of the country and provides economic stability. A central bank is not like commercial banks, as it does not have direct interactions with the public. Rather, it operates behind the scenes to:
- Issue and control the currency
- Control inflation and set interest rates
- Oversee and control commercial banks
- Hold foreign exchange reserves
- Serve as banker to the government
Examples of Central Banks
- Reserve Bank of India (RBI) – Indian central bank, manages monetary policy, currency, and regulation.
- Federal Reserve (USA) – Manages U.S. interest rates, supply of money, and inflation level.
- European Central Bank (ECB) – Manages Eurozone countries’ monetary policy.
- Bank of England (BOE) – Ensures the UK’s financial and monetary stability.
They are all autonomous but with the common goal of financial and economic stability.
| Country | Central Bank Name |
| India | Reserve Bank of India (RBI) |
| United States | Federal Reserve System (Fed) |
| UK | Bank of England |
| EU | European Central Bank (ECB) |
| Japan | Bank of Japan (BOJ) |
Core Functions of Central Bank
The central bank is a critical institution in managing the economy of a country. It is the most powerful financial body to govern the monetary and banking system of a country in order to ensure economic stability and financial well-being. Whether it be controlling inflation, supervising commercial banks, or managing foreign exchange, the central bank is at the heart of the financial welfare of any economy. Consider a central bank’s primary functions to stabilize and propel the economy.
Development and Application of Monetary Policy
The most significant task of the Reserve Bank is to formulate a monetary policy for the country. It drives the country’s economic activity by manipulating these: interest rates, reserve ratios, and the degree of liquidity. Repo rates, reverse repo, CRR, SLR, and open market operations formulate the currency’s deployment in controlling inflation, facilitating investments, and regulating money supply.
Legal issuance and circulation of currencies
A nation’s central bank is the only centre with legal prerogatives to issue legal tenders. The economy becomes well balanced and can control counterfeiting and inflation; hence, an eco-balance is maintained. For example, the RBI has the exclusive right in India to issue currency (not coins, which the government issues).
Bank Regulation and Supervision
Besides, it functions as the supervisor for the banking industry, holding all commercial banks to the prudential regime as regards the minimum capital, ceilings on non-performing assets, and rules on disclosures. Periodic inspections, audits, and compliance checks are in place for depositors’ vaults to ensure integrity in the financial ecosystem.
Lender of last Resort
Under these conditions, Last Resort Lender bestows finance on commercial banks when they encounter distress situations where they cannot repay their debts. It ensures that there is no comprehensive failure of banks and maintains public confidence in the financial institution. Such a role becomes critical in economic crises experienced in the global financial meltdown or COVID-19.
Credit Control and Liquidity Regulation
The central bank controls the money supply with different quantitative and qualitative instruments to regulate the money flow in the economy. It uses repo rate, SLR, and open market operations to avoid inflation or recession. Regulating the credit supply provides proper money circulation in the economy.
Banker to the Government
The central bank regulates the government’s accounts, serves as a financial counselor, and handles issues of government bonds and treasury bills. Public debt also comes under control in central banks, as well as the provision of short-run cash facilities for support using the likes of Ways and Means Advances (WMA).
Foreign Exchange Management
The central bank facilitates stable foreign trade with exchange rate management and foreign exchange reserves. The central bank monitors exchange rate fluctuations and intervenes in the foreign exchange market to maintain volatility within bounds, particularly during economic uncertainty or capital flight.
Developmental Role (Particularly in Emerging Economies)
Developing economy central banks promote inclusive growth by promoting rural banking, microfinance, and electronic payments. For instance, the RBI promotes the use of BHIM, UPI, and Jan Dhan Yojana to enable cashless and inclusive banking.
Financial Market Stability
The central bank continuously monitors threats to the financial system and takes action to avoid contagion. It releases financial stability reports and collaborates with global financial institutions to ensure resilience during economic stress.
Tools Employed by Central Banks to Control the Economy
Regulation of money supply and credit to ensure economic stability is one of the most significant central bank and monetary policy roles. Regulation is done through a range of tools broadly classified into
- Quantitative tools, which influence the total supply of money in the economy
- Qualitative tools, which determine the manner and location of credit distribution
Both sets of tools assist central banks in dealing with inflation, stabilizing currency, spurring investment, and regulating market liquidity.
Quantitative Tools of Monetary Policy
They also refer to general credit control measures. They seek to control the overall amount of credit within the economy.
1. Cash Reserve Ratio (CRR)
The ratio of a commercial bank’s total deposits must be held as reserves with the central bank.
Example: If CRR is 5%, then a bank with deposits of ₹100 crore needs to keep ₹5 crore with the central bank.
Effect: Raising CRR decreases funds for lending, curbing inflation. Reducing CRR raises liquidity, stimulating investment.
2. Statutory Liquidity Ratio (SLR)
The minimum proportion of banks’ net demand and time liabilities (NDTL) is to be held in gold, government securities, or cash.
Purpose: To maintain bank solvency and limit excessive credit expansion. A higher SLR decreases a bank’s ability to lend; a lower SLR enhances it.
3. Repo Rate
The interest rate at which the central bank lends short-term money to commercial banks against securities.
Effect: Higher repo rates increase the cost of borrowing, lowering the money supply; lower repo rates stimulate borrowing and liquidity.
4. Reverse Repo Rate
The interest rate at which the central bank borrows money from commercial banks. It is utilised to mop up excess liquidity from the banking system. A high reverse repo rate encourages banks to keep money with the central bank, which curbs lending.
5. Open Market Operations (OMO)
The central bank buys and sells government securities in the open market.
- Buying securities: Pumps money into the economy (utilised during deflation).
- Selling securities: Mops up excess money (utilised during inflation).
6. Bank Rate
A rate of interest on a long-term basis at which the central bank lends to commercial banks without collateral. Effect: Like the repo rate, but tends to affect the economy more slowly.
Qualitative Tools of Monetary Policy
Qualitative tools, or selective credit control measures, are employed to direct or channel the credit in the economy.
1. Moral Suasion
A non-coercive technique by which the central bank induces commercial banks to follow monetary policy standards.
Example: Refraining from lending to speculative industries such as real estate during inflation.
2. Credit Rationing
Banks place limits on the level of credit for a given purpose. This may be through placing quotas or limits on credit to certain sectors. Helps in controlling over-lending to non-priority industries and ensuring adequate flow to priority industries.
3. Margin Requirements
It is the divergence between the price of the loan and the offered collateral. Speculative assets may have their margin requirements raised by the central bank to restrict lending against them.
4. Direct Action
The penal action may be imposed upon those banks by the central bank if they refuse to follow orders, like an increase in CRR or a withholding of rights of borrowing.
Why Are These Tools Important?
These central bank and money policy actions are essential for:
- Controlling inflation or deflation
- Providing an adequate flow of credit to productive segments
- Controlling economic cycles (boom or recession)
- Ensuring financial stability
Through a combination of these instruments, the central bank provides for sustained economic growth without running into overheating or a downturn.
How Does Central Bank Control Inflation?
One of the most essential functions of the central bank is controlling inflation. Inflation eats away at purchasing power and causes economic instability; hence, price stability is a top priority.
The central bank employs methods such as
- Repo Rate: Raising the repo rate discourages borrowing and decreases money in the market, thereby lowering inflation.
- Cash Reserve Requirement (CRR): Banks are forced to retain more money with the central bank by raising the CRR, thus decreasing the money supply in the economy.
- Open Market Operations (OMO): Government securities are sold to absorb excess liquidity, which checks inflationary pressures.
- Inflation Targeting Framework: The RBI has a flexible inflation targeting regime of 4% ± 2%, refashioning policies based on CPI data.
With these, the central bank balances growth and price control.
Difference Between Central Bank and Commercial Bank
Understanding the difference between a central bank and commercial banks makes it more straightforward to comprehend the individual role of each.
| Aspect | Central Bank | Commercial Bank |
| Objective | Economic stability and regulation | Profit-making |
| Currency Issuance | Sole authority | Cannot issue currency |
| Public Dealings | No direct dealings | Deals directly with individuals/firms |
| Lender of Last Resort | Provides emergency funds to banks | No such role |
| Banker to Government | Yes | No |
| Regulated By | Self-regulated | Regulated by the central bank |
| Monetary Policy Control | Yes | Follows central bank directives |
This distinction reinforces central banks’ regulatory and macroeconomic role compared to commercial banks’ retail and credit-granting activity.
Central Bank Functions FAQs
1. What is the primary function of a central bank?
Its primary function is to regulate the money supply and stabilise inflation through monetary policy and interest rates.
2. What are the constraints of a central bank?
It cannot control all economic parameters like fiscal deficits or foreign shocks. Its instruments also have delayed impacts.
3. Who controls the central bank?
Ownership is mixed—some central banks are entirely government-owned (e.g., RBI), whereas others are partly autonomous.
4. Does every nation have a central bank?
Every nation has one, though some tiny countries may use currency unions or imitate foreign money.
5. What is the function of central banks in stabilising economies?
They stabilise economies by managing interest rates and inflation and serving as a lender of last resort during the crisis.
